Regulating Equity Crowdfunding in India

[The
following guest post is contributed by Arjya
Majumdar, who is an Assistant Professor at the Jindal Global Law School. He
can be contacted at [email protected]]

In the aftermath of the 2008
financial crisis, small businesses found it increasingly difficult to raise
funds. As a response, crowdfunding has emerged as a viable alternative for
sourcing capital to support innovative, entrepreneurial ideas and ventures. With
the swift growth of the crowdfunding industry, risks associated with it have
also come into sharp focus. According to a World Bank commissioned report in
2013, Kickstarter, the market leader
in pledge or donation-based crowdfunding, has channeled over USD 815 million
from 4.9 million backers to nearly 50,000 projects throughout the world,
between 2009 and 2013. By March 2014, Kickstarter had surpassed USD 1 billion.

In India, the Securities and
Exchange Board of India (SEBI) released a consultation
paper in 2014 which, inter alia, proposes a framework for ushering in
crowdfunding by providing start-ups and small-and-medium enterprises (SMEs) access
to the capital markets and to provide an additional channel of early-stage
funding. A brief background and the purport of the consultation paper may be
found here.

A number of issues arise concerning
crowdfunding in India – the first of which is the requirement of regulating crowdfunding,
particularly when pre-existing securities laws may be interpreted to include
crowdfunding activities. The nature of crowdfunding is inherently different
from venture capital and public funding. This sets up the foundation for which
a separate exemption may be carved out of existing securities laws. There are several
primary risks arising out of equity crowdfunding which must be addressed by any
securities regulator seeking to regulate this mechanism.

The first risk involves the
possibility of a large number of likely non-sophisticated investors in an
early-stage company, which has a high chance of failure making it an added
complication. Because of the low cost of capital and the relative ease with
which entrepreneurs may access and engage with crowdfunding portals, crowdfunding
has been used by many startup companies to raise smaller amounts of money for
their initial stage. Startup companies have an inherent risk of failure.
Failure statistics universally show that over 50% of newly founded firms will
fail during their first five years.

Crowdfunding portals and their
operations create concerns as well – primarily due to the lack of a secondary
market. Typically in a company which has issued securities to the public, such
securities are freely tradable on stock markets. The Companies Act, 2013 also limits
restrictions on transferability of public, listed company shares. Conversely,
crowdfunded securities cannot be traded on crowdfunding portals as on date –
leading to illiquidity. As a result, contributors cannot sell their securities
to recoup their investments. This risk is exacerbated in cases of default or
fraud, where an immediate exit option from the company does not exist.

At the same time, equity
crowdfunding offers a number of advantages, the largest of which – curiously
enough – is the lack of regulation. Companies that raise funds from fifty or
more investors are required to undertake a public offer, regulated under the
Companies Act, 2013 as well as the SEBI (Issue of Capital and Disclosure
Requirements) Regulations, 2009. Using the Internet, an entrepreneur can sell
an idea that is viable and can be monetized to literally millions of potential
investors. No intermediary such as a merchant bank or an underwriter is needed.
Other advantages include the spreading of risk and the boost to the economy
through encouragement in the growth of SMEs.

In India, companies are prohibited from
offering to issue shares to more than 200 potential investors in a financial
year or from allotting shares to 50 or more shareholders, without undertaking a
public offer. A public offering of shares or convertible debt securities
involves the appointment of one or more merchant bankers, a registrar to the
issue, filing of a draft offer document with SEBI, eligibility requirements
such as previous track record, minimum promoter’s contribution, lock-in
requirements, requirement to have a monitoring agency, etc., apart from
detailed disclosure requirements.

Legislation exempting crowdfunding
activities from traditional securities laws have been passed in a number of
other jurisdictions, beginning with the United States. Other countries,
including Italy, New Zealand, the United Kingdom and Australia have followed
suit. Three regulatory regimes can be identified in equity crowdfunding. In the
first case, regulation prohibits equity crowdfunding in its entirety while
reiterating the existing law on fundraising by companies. In the second case,
countries have begun to consider crowd funding as a new way of raising capital
and that it falls under the regulation of public offers of securities. In the
third case, several countries have adopted tailored regulations which seek to
encourage this financing without apparently compromising investor protection

Similar to the Jumpstart Our Business
Startups (JOBS) Act in the US and other legislations around the world, SEBI’s
consultation paper also seeks to create exemptions for crowdfunding activities.
This raises the second issue involving a comparison of SEBI’s proposed
regulations, particularly in terms of eligibility criteria for fundraisers and
contributors, mechanisms, levels of disclosure and independent accreditation, etc.,
with that of other jurisdictions.

Policymakers continually face the
challenge of effectively balancing the benefits of encouraging small business
formation against the investor protection goals of the securities laws. This
challenge becomes even more pronounced in the case of crowdfunded companies
which typically are small and medium enterprises. In terms of the existing law
on raising capital, a proposition may be made that the present-day law in India
makes it impossible for crowdfunding activities to occur. Any exemptions
offered to crowdfunding activities must still address certain basic issues concerning
information asymmetry, agency costs and investor protection at the very least. A
review of SEBI’s consultation paper would ascertain whether the principles
followed by SEBI in regulating this sector would culminate in the development
of crowdfunding activity, or stifle it.

At the same time, SEBI’s
consultation paper does not take into account two key aspects of crowdfunding.
The first is that of peer to peer lending – when the proceeds of crowdfunds are
issued to an individual and not a company. The second is that of cross-border
crowdfunded companies. Given that crowdfunding is typically facilitated by
web-based portals and promoted through social media and other internet-enabled
networks, it is likely that crowdfunding activities will transcend national
boundaries. Perhaps suitable checks and balances could be designed into Indian
crowdfunding regulations.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

I agree that the foremost point of discussion in SEBI's consultation paper should have been how existing laws without any specific amendments are inadequate to properly address the issues arising out of crowdfunding activities. I had the opportunity to coauthor a paper published on EPW (available http://www.epw.in/commentary/crowdfunding-india.html) where we discussed in length this issue.

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